The debt hawks are to economics as the creationists are to biology. Those, who do not understand monetary sovereignty, do not understand economics. Cutting the federal deficit is the most ignorant and damaging step the federal government could take. It ranks ahead of the Hawley-Smoot Tariff.
==========================================================================================================================================

The Fed raises interest rates to fight inflation. To fight recession, the Fed does the opposite. It cuts interest rates.

This may sound logical except for one, very small detail. The opposite of inflation is not recession. The opposite of inflation is deflation. So doing the opposite of what you would do to counter inflation makes no sense when trying to counter a recession.

We could have a recession with deflation. We could have a recession with inflation, which is called “stagflation.” The history of Fed rate cuts, as a way to stimulate the economy, is not a good one. The Fed, under Chairman Greenspan, instituted numerous rate cuts. The result: A recession that President Bush’s tax cuts cured.

Why does popular faith hold that cutting interest rates stimulates the economy? Because popular faith views only one side of the equation. But, for each dollar borrowed a dollar is lent. $B = $L.

Cutting interest rates does cost borrowers less. A business needing $100 million might be more likely to borrow if interest rates are low than when they are high. Further, consumers are more likely to spend when borrowing is less costly. So making borrowing less costly stimulates business growth and consumer buying. At least, that is the theory.

What seems to be ignored is the lending side of the equation. When interest rates are low, lenders receive less money. And who are the lenders? Businesses and consumers.

You are a lender when you buy a CD or a bond, or put money into your savings account. When interest rates are low, you receive less money, which means you have less money to spend on goods and service — which means less stimulus for the economy.

In short, interest rates flow through the economy, with some people and businesses paying and some receiving. Domestically, it’s a zero-sum game — except for the federal government.*

A growing economy requires a growing supply of money. Cutting interest rates does not add money to the economy. That is why there is no historical correlation between interest rates and economic growth. During periods of high rates, GDP growth is not inhibited. During periods of low rates, GDP growth is not stimulated.

Please review the following graph:

Blue is interest rates. Red is GDP growth. Not only are low interest rates not associated with high economic growth, but the opposite seems to be true. There seems to be a correlation between high interest rates and high GDP growth. How can this be?

*When interest rates are high, the federal government pays more interest on T-securities, which pumps more money into the economy. This additional money stimulates the economy.

This shows why the Fed’s repeated rate cuts do not seem to stimulate the economy. The action has been shown, time and again, to be counter-productive. Cutting interest rates to stimulate the economy is like pouring water on a drowning man.

Do you remember these headlines: “Employers slashed 80,000 jobs in March.” “The U.S. central bank has lowered rates by 3 percentage points since mid-September” “The loss of jobs signals another interest rate cut by the Federal Reserve later this month.” “Federal Reserve Chairman Ben Bernanke acknowledged Wednesday that the country could be heading toward a recession, saying federal policymakers are ‘fighting against the wind’ in combating it.”

Rate cut after rate cut did nothing. So what was the Fed’s plan? More rate cuts. During the previous recession, the Fed also attempted rate cut after rate cut, also to no avail. The recession, finally ended with the Bush tax cuts. The Fed has not learned from experience, but stubbornly adheres to the popular faith that interest rate cuts stimulate the economy.
Rate cuts do not stimulate the economy. They never have. They never will.

“Stimulating” an economy means making it larger. A large economy requires more money than does a smaller economy. Therefore, the only thing that stimulates the economy is the addition of money.

Rate cuts, by reducing the amount of interest the federal government pays, actually reduce growth of the money supply. We are on the edge of a recession, because the economy is starved for money. The coming “stimulus” checks will help, but they are too little and too late. This should have been done months ago, and the amounts should be far larger.

The only way to prevent or cure a recession: Federal deficit spending. There is no excuse for recession or inflation. These problems are not economic failures. They are leadership failures.

Like this:

Related

15 Responses to –The low interest rate/GDP growth fallacy

The graph seems to show a “traditional” correlation between interest rates and GDP growth, possibly with a time lag. What would the graph look like if you (1) used “real” GDP, and (2) adjusted the timing by 1 or 2 years between change in interest rate and GDP response?

There was crippling inflation in the early 1980s. The cause may be that the Fed kept lowering interest rates for too long.

Rod,
By “traditional,” do you mean when interest rates are high, GDP growth is low? If so, I don’t see it.
The graph seems to be the classic no-correlation example, where some years seem to “prove” one point and other years seem to prove the reverse. I see no consistency that could be called “correlation.”

Rodger,
I have read and I am back. In your dialogue in this “low interest rate fallacy”, I agreed with your narrative until the last sentence.

If federal deficit spending were the only way to prevent or cure a recession, we would not be in the recession we are in.

From the end of the last recession, or appx. 2001 until 2007-08 when this recession began, deficit spending increased disproportionately to any time since the end of the gold standard.

I am sure you are going to say the deficit spending was not enough. Do you not see a relationship in deficit spending and increased debt? Not necessarily gov’t debt, but total debt. Deficit spending by the gov’t gives rise to fractional banking’s increasing private debt.

The actual cause of our current situation being an extremely bloated, or ballooning of the private and business debt. Due mainly to deficit spending, thereby increasing spending power of the public through debt.

Federal spending is not the only way to prevent or cure a recession. Cutting taxes is another way. Both are identical in that they add money to the private sector.

Early in 2008, I was furiously writing to economists, politicians and the media, telling them that $150 billion original stimulus (remember that?) was way to little and far too late. (See my letter to the Chicago Tribune, April 9, 2008 at http://www.rodgermitchell.com/medialetters.html

At the time I thought $500 billion to $1 trillion would do it, which it probably would have if done immediately. Although the government at long last has allocated more than $1 trillion to the effort, it has yet to spend much of it.

Even worse, the recipients of TARP money are now removing billions from the private sector and returning it to the government. Why. Because taxpayers believe it is taxpayer money. Ouch.

Yes, federal deficit spending can increase private debt. Thankfully. The private sector grows by borrowing and building. The biggest problem now is lack of lending, i.e. lack of private debt growth. Too much lending was not the precipitant. Bad lending was.

Perhaps the most important cause of our current situation is the reduction in federal deficit growth that occurs prior to every recession (Increases in deficit growth cure all recessions.) See the graph at the post “I believe.”

By the way, very few people understand what I am about to tell you. Fractional banking does not work the way people think. It is not a case of: Banks receive deposits; then banks lend deposits. In fact, (this will amaze you) banks’ lending causes the deposits. The lending comes first. A bank can lend with no deposits. But don’t fixate on that until we get past the more elementary stuff.

Thanks, Rodger. I see the federal funds rate dropping sharply at the end of Carter’s term, and then GDP rises until mid-1981. In late 1982, Volcker sharply drops the federal funds rate, and again GDP rises.

Of course, Alan Greenspan’s Federal Reserve sharply raised interest rates in 1994, and we all remember how strong the economy was in the Clinton years.

I now understand why this subject elicits lively debate between yourself and the MMT’rs.

And I see the FF and GDP both reach their nadir in 1980, then both climb to reach a peak in 1981. Then in 1982, FF rises, as does GDP, both falling together toward the end of 1982, then beginning to rise again — together. Also, the graph in the original post shows FF and GDP changes essentially parallel.

That said, I do not believe interest rates are the prime mover for GDP. Although high rates do seem to have a mildly stimulating effect, the prime mover is federal deficit spending.

Both high interest rates and federal deficit spending add dollars to the economy.

How would would one determine the appropriate federal funds rate at any given time?

2% … 5% …15% …and so on.

What possible situations do you foresee that it makes sense to increase the federal funds rate? And, maybe more importantly, what possible situation would signal to you that the rate should stop increasing or start decreasing?

I view the main function of the ff rate is to prevent inflation. So today, the zero rate actually seems appropriate. Though a zero rate minimizes the federal deficit (bad), the government can make up for it via spending. I gradually would increase the rate if inflation were expected to go above 2%.